Atlanta, GA. (Jan. 19, 1999) -- Earnings season has arrived, so there appears to be lots to choose from this week. But first, a lesson in why the rising margins screen should be approached with some critical scrutiny.

Last week, DMI Furniture(Nasdaq: DMIF), a vertically integrated manufacturer, importer, and marketer of residential and commercial office furniture, reported a 62% jump in Q1 EPS to $0.21 on a 32% increase in sales to $23 million. Sounds awesome, but check the fine print. Diluted shares outstanding dropped 29% to 4.3 million from 6.1 million thanks to the retirement of preferred stock last August.

Despite the terrific sales increase, DMI's profit margins actually declined for the quarter. Gross margins sank to 21.8% from 23.7%, operating margins fell to 8.2% from 9.0%, and net margins dropped to 3.9% from 4.6%. While these numbers may include some one-time costs from creating new divisions that hopefully will produce long-term growth, DMI actually fails our margins screen.

A company that passes the basic screen is Funco(Nasdaq: FNCO), a retailer specializing in new and used video games and related hardware and accessories. The company now operates 310 FuncoLand stores, up from 249 a year ago. Funco reported that Q3 sales shot up 24% to $82.9 million, pumping up EPS by 38% to $0.87. Comp-store sales jumped 7%.

All of that looks terrific, but not so fast. The company has been buying back shares (which is good) and followed up its earnings release with word that its board had increased its authorization by another 300,000 shares, meaning the company can repurchase about 400,000 shares, or 6.5% of the total now outstanding (also good). What's bad here is that most of the EPS gain came thanks to the buybacks. All things being equal, there are simply more earnings per share when there are fewer shares. Q3 net income increased 30%, still strong, but not as impressive as the 38% EPS gain.

The press release explains what happened. Sales of new products rose 58%, but that shifted the sales mix. These lower-margin new products accounted for 66% of revenue in the quarter versus 51% a year ago. The company chalked this up to "growth of the Sony PlayStation and Nintendo 64 product categories." I'm not a gamer, so I don't have any special insight on this shift, but it clearly had an impact on net margins.

What's more, the first six months of FY99 had been disappointing for Funco. Net profits and EPS had actually declined despite a 13% jump in comp-store sales. That's not at all what you expect to see. The problem was contracting gross margins due to the changing product mix.

Still, the company's sales are growing faster than the industry. It's also got at least some online (www.funcoland.com) presence, with year-to-date Internet sales of $1.25 million. And the Fool Snapshot reveals a company with no long-term debt and 26% return on equity (ROE). Though Funco missed its Q3 estimate by two cents, consensus estimates of $1.56 per share for the year ending in March and $1.82 per share for FY00 should probably be discounted only slightly. At $13 1/2, then, Funco trades at just 7.4 times next year's earnings, or less than half the growth rate implied by those estimates. Yes, it's a small cap, but worth a closer look.

Activision(Nasdaq: ATVI), another game distributor, also makes our screen, though I wonder if it should. The company delivered a 58% increase in Q3 revenue to $194 million. Activision is tricky, though, because while net income soared 73%, fully diluted EPS increased just 56% to $0.64. Common share equivalents increased by over 4 million during the quarter, and the earnings release doesn't explain why. It could be related to the firm's outstanding convertible debt, but possibly it's something else. Something to check on.

Nonetheless, this once troubled company that distributes such popular games as Jack Nicklaus: Golden Bear Challenge and id's Quake II has boosted revenue for the first nine months of the year by 54% to $312 million. Sales through its website (www.activision.com) increased 55% from November to December. CEO Robert Kotick expects sales to rocket from $400 million for the year ending in March to $550 million next year.

Consolidation in the video/PC game market promises to make the remaining players stronger. The advent of online distribution and multi-person online games could eventually change the economics of the business in ways that might prove quite favorable to both distributors and content providers, though that's yet to be seen. Today, however, Activision claims pretty thin profit margins, something reflected in the company's low 10% ROE found in the Fool Snapshot.

The stock does trade for just 16 times estimates for the year ending March 2000, quite a discount to the 30% earnings growth included in those estimates. On the other hand, inventories appear to be running high, up 112% year-over-year. Even with new product offerings, I'd prefer to see inventory growth closer to revenue growth. Though Activision is sexier -- and larger -- than Funco, I would check out the Funco first. Nothing like buying a little fun, right?

On a closing note, congratulations to my hometown Atlanta Falcons. Those Dirty Birds hung around against the favored Minnesota Vikings even when all seemed lost. After 32 years of losing, it's awfully sweet to win. Super Bowl, here we come!

dividend adjusted. Dividends have been added to the total return of the index.

 DJIA (DA) =

dividend adjusted. Dividends have been added to the total return of the DJIA.

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